Essential Stock Market Lessons – Part 1: Mastering Market Cycles

I’ve decided it’s about time I stop boring you lengthy, text laden rants about my share market antics and get into something juicy – something that you can really take home and help make you a better investor. I was pondering what to write about when I looked at the calendar and realized it’s been almost three years since I first dipped my toes in the markets way back in 2012.

I have so much that I could talk about, but decided I’d initially start a short series of posts outlining the three most important investing lessons that I’ve learned so far. I think these next three posts are hands down the most valuable I’ve written for the beginner investor (or seasoned pro for that matter).

Because I know from cold hard experience (often painful) that understanding these three key concepts alone has helped me transition from losing out big time on 90% of my of my investments, to winning far more than I’ve been losing…and it’s had a HUGE impact on my bottom line.

Not only that but the ideas I’m about to discuss are so simple, they sound like nothing more than common sense. The funny thing is – that’s all they are! But I think you’ll be surprised how little people actually stop think about the little things that make the biggest difference.

So go grab a coffee and get yourself comfortable because today I’m going to be talking to you about…

The importance of understanding the cyclical nature of the market.

O.k. so I know that topic headline hardly gets the juices flowing right off the bat, but hold off from clicking the back button just yet and hear me out because I am going to tell you why understanding of the cyclical nature of the market is probably the single most important thing you can do if you want to make a successful go of investing in the markets.

Trust me, I know from experience – not understanding this (at least with any real insight) was probably the biggest contributing factor to most of my big losses in the early years playing the stock market.

You see, I knew that stock markets go up and down. I knew the terms “bull” and “bear” markets and was well aware of periodical sell offs (the dot com bust, the GFC et. al.). I knew bull markets averaged between four and eight years (depending on who you ask). In fact, “knowing” this actually cost me a lot of money in the form of opportunity cost as I sat on the sidelines during one of the biggest market bull runs in history, waiting for the correction/recession to arrive that never came.

Bar graph showing the longest bull markets in US history. The current bull run the third longest in history (Source: money.cnn.com).

It turns out that I didn’t know nearly as much as I thought I did. My thinking regarding market cycles was elementary and “surface level” and I have since discovered the market is a highly complex beast – it doesn’t move in harmonious union and there are parts that do well whilst others languish or fail.

In my humble opinion, figuring out which markets, and sectors within markets, are going to perform at a given time is the most useful (but also most difficult) thing an investor can do.

So it’s time to hunker down and explore some key sub-points to the whole “market driven by cycles” concept:

The bread and butter “market cycle” concept. No rocket science here, but I feel it’s time for a case study from my very own experience which explains the whole “shebang” well.

The year is 2012 and I was just getting into the whole investing thing (if you want to read more about my “unremarkable” life and how I got into investing, read here). Mining shares were where it was at for me – largely because I was a geologist and mining shares were what my peers and colleagues were talking about. Mining stocks were also in vogue, largely because the mining sector as a whole was in the midst of it’s biggest boom periods in history.

I’d also made a conscious decision not to invest in the most popular blue chip, dividend paying stocks that everyone had started flocking to, thinking they had seen 4+ years of constant growth and were probably due a breather, such was the extent of my “cycle thinking”.

What I should have done is dug a little deeper, looked under the hood a little better. If I had, I (hopefully) would have realized that the mining industry is probably one of, if not the most cyclical industries, and it had been booming for the better part of a decade!

Check out the chart below and you should be able to see what I am talking about. You will see the a chart containing two lines representing two separate indexes that track the mining industry in general – one for smaller companies (such as speculative exploration outfits) – the Small Resources Index, and and another which tracks the larger mining and mining related companies – the ASX300 Metals and Mining Index.

Chart showing the performance of the Metals and Mining and Small Resources indexes on the ASX. Note the obvious bubble inflating from about 2003.

What should stick out like dogs balls is the point in early 2003 where the indexes went parabolic and jumped way up above the long term growth trend – a sure sign that a bubble is full swing.

Turns out I was avoiding quality banking and dividend paying stocks like the plague, largely because I thought there was a chance they were in a “bubble”, all the while buying up mining stocks near the absolute peak of the biggest bubbles ever seen in Australian stock market history!

The chart clearly shows that the mining boom cycle has come to a spectacular end and the global commodities deflation has been in full force for the better part of the last two years, something I witnessed first hand working on the ground in the mining sector in Western Australia.

2. Boom (bull) periods are often followed by a reversion to the long term trend.

One interesting thing you’ll often notice is that at the end of bull markets, price will generally revert to the long term trend. This happens time and again and when this occurs, it’s often a sign that a bottom of a bear market is near. You can clearly see this type of behavior in the chart above as both indexes are now very close to their long term average trend line.

You see this not just in commodity markets, but in almost every market that has ever existed. This phenomenon seems to occur across almost all time scales, from short (i.e. minute to hourly scale on a trending stock) right through to a decade or longer cycles such as over the entire history of the stock market as shown below. Just be careful because often times the market will over/under-shoot the trend line on it’s way to reverting to it’s long term average – A prime example being the Small Resources index above which looks to have just shot beneath its long term average (possibly signalling a good buying opportunity).

Long term stock market growth average. Note the constant reversion to the long term average over time. (Source: visualizingeconomics.com)

I’ve mentioned the bear market case whereby prices often correct downwards to the long term average. It’s also worth noting that the converse is also true. Heavily sold off sectors will, more often than not, also bounce back upward to the mean (and often above) – something worth keeping in mind.

3. A rising tide lifts all boats.

Another key thing I’ve learned is that the saying “a rising tide lifts all boats” definitely applies to markets. By that I mean that markets tend to act like the tide – money flows into a sector (a rising tide) and most stocks within that sector will rise, almost regardless of their fundementals. Unfortunately for me, I’ve learnt the hard way that the converse is also true.

I will refer you again to the mining index chart above where I have labelled where I started making my first stock market investments. I didn’t quite buy “at the peak”, but I wasn’t far from it. What that chart tells you is that, on average, the mining sector as a whole declined by almost two thirds from the time I started investing until today. Money hasn’t just trickled out of the sector – it’s been a torrent!

I can tell you right now, there was barely ANY mining stock that would have made people money during that time. I said barely because there are some sectors (and individual stocks) that had periods of out performance, however these stocks have been very few and far between.

I couldn’t understand why quality mining companies with good deposits, solid management and huge money making potential were sliding down the proverbial toilet, meanwhile the rest of the stock market was making new highs just about every other day. I didn’t understand that although the broader (non-mining) market was performing well, the mining sub-market was in the early throes of a climactic bursting bubble – meaning any investment in a mining related stock was likely to end in failure.

The point I’m trying to make is, trying to make money from investments in declining market (or market sectors) is nigh on impossible. It’s like trying avoid a crash landing in a hot air balloon by turning the gas on full blast even though the balloon itself has a gaping hole – chances are there’s nothing even the most skillful pilot could do to keep the balloon afloat. It’s going to be very, very difficult to pick a winner if money is moving “en masse” out of a sector.

On the bright side, it can actually be far simpler than you think to make money in the stock market – simply find a half decent company in a rising sector of the market and “hey presto” – your portfolio’s in the green! O.k. so it’s not quite that simple, but in all honesty, that’s actually not too far from how things work in reality.

Let me draw your attention to the chart below which illustrates my point. The graph shows the price action of six very different companies from four completely different sectors of the market. “But they all look so similar” you may be thinking…Well you would be correct.

It seems bizarre, and as I was making the chart I was actually a little stunned as to how similar they have all behaved. Six completely different businesses, with completely separate fundamentals, acting almost in unison. However, it is no coincidence that three banks, an insurance company, a telecoms outfit and a supermarket chain have all experienced almost uncannily similar share price growth over the past few years.

Chart showing a wide range of high dividend yielding stocks from completely different sectors, all showing a very similar price pattern

You see the one thing they all have in common is that they are all high yielding dividend stocks. It now makes perfect sense that they coupled around mid 2011, right at the time when it became clear that interest rates were going to remain at unprecedented lows for some time as part of the post GFC stimulus efforts carried out by central banks around the globe.

All of a sudden people who relied on fixed income, traditionally in the form of interest from their savings account or term deposits, were receiving next to nothing. The entire globe was forced into high yielding equities to provide that income, hence why we have seen a flood of money flowing into high yielding stocks.

I guess you could say the past five or so years has seen a “yield boom” – you can literally see the metaphorical “tide” rising in the chart above, lifting all the dividend paying stocks with it. I should have realized that anemically low interest rates around the world would drive money into high yield equities and jumped into them, rather than avoided them. I should have chosen the to flow with the rising tide.

It’s no secret that while some sectors “thrive”, others take a “dive” and vice versa. To beat a dead horse, the recent activity in the mining sector is a classic example of this – just about all other sectors were moving in one direction (the one we all like), whilst mining stocks were doing the total opposite.

Cue the chart below which compares the S&P ASX 200 index with the Small Resources index I’ve mentioned elsewhere in the post. The S&P ASX 200 tracks the 200 largest companies in the ASX so is a good guide as to how the “overall” market is performing. You’ll note the stark divergence between the two, beginning in earnest around the middle of 2012 (right when I started investing…just my luck). Since then, the S&P/ASX200 is up 32% while the Small Resources Index is down a whopping 64%.

Comparison of the S&P ASX200 index (biggest 200 companies on the ASX) with the Small Resources index

You can even have out performing segments within sector. A quick example of this is the graphite industry which has experienced a number of boom periods over the past few years during a time in which the overall mining industry has been in free fall. The chart below highlights the graphite boom (and subsequent bust) in mid 2014, stoked largely by industry wide takeover rumors and hype surrounding graphite as the material of the future. Note the rapid rise and equally rapid fall.

It is interesting to note that of late there has been some signs of renewed interest in the graphite space as a “commodity of the future” and we are possibly seeing the beginnings of another upswing in graphite.

Learning to spot and pick the hot (and avoid the “not”) sectors is a highly valuable skill for any investor and can be a highly lucrative undertaking.

Chart showing three seperate graphite stocks listed on the ASX showing the graphite “boom” periods of recent years.

How to take advantage of market cycles.

I figured it’s all well and good discussing the ins and outs of market cycles but it’s only useful if I give you something actionable, something you can actually do to improve your investing and trading. The following is a list of things that I try to put into practice. All are based on the understanding that markets move in various cycles and taking advantage of the low points in those cycles can yield impressive results.

So here goes…

Never buy stocks in market sectors that are clearly in a down trend. Trying to pick a bottom is nothing but gambling and should be avoided at all cost – wait until the cycle turns and a bottom has formed.

Do this by looking at sector indices (a quick google search should do it), or at the very least examining the charts of a handful of other prominent stocks in the sector.

Avoid buying stocks that have had a rapid, parabolic rise. See the chart of graphite stocks above as an example. Things that rise rapidly tend to fall back down just as fast.

Buy stocks that are in a slow but steady up trend, in sectors that are also in an up trend, and hold them until there is a clear sign of a trend change i.e. the break of a major trend line.

Buy quality stocks in un-loved sectors at the low point in their cycle once they have formed a decent base. Be sure to have a tight stop loss set for just beneath the horizontal base in case the down trend resumes.

Keep an eye on the bigger macro economic picture. This can help alert you to global events that may trigger a change in trend in global markets. Some easy ways to do this include:

Read the world and business sections of your local newspaper to stay up to date with current events.

Sign up for economic magazines, either in hard copy or electronically.

The current Dow Jones Industrial average is a classic example of consistent rising trend line. Buy during an up trend and sell when price crosses below the trend line.

Example of a stock which has formed a base after a long down trend. Buying a basing pattern with a tight stop loss can provide a great entry point.

To Conclude

Markets are highly cyclical beasts, and understanding this concept is probably one of the most important things you can do as an investor. No one ever picks the absolute bottom of a cycle and sells at the very peak time and time again (anyone who tells you otherwise is a straight up liar), but stopping to think about where a market is in it’s cycle can help you avoid investing disasters like those I experienced when I first started trading.

Thinking cyclically can help you identify beaten down sectors within the market that are due a rebound and provide you with low risk entry points in which to make investments. Following the cycle through it’s entirety by going with a trend will help you maximize your gains and take advantage of the majority of a bull market.

On that note, I’ll leave you with a famous quote that sums up this post perfectly (and just so happens to be from someone who understands the markets better than anyone):

“Be fearful when others are greedy, and greedy when others are fearful” – Warren Buffet

There are 3 Comments.

Identifying market cycles and knowing when market stages are aboutvto change is a little more difficult that you put on. I’ve been working on a fundamental+technical model to predict market stages, and after half a year of working on this I think I’m getting close to a decent model.

I mean, yes and no. It’s obviously impossible to write everything you need to know about market cycles in one post. I also think it’s impossible to tell with any accuracy when a market is due to change, hence why the brightest minds and smartest central bankers haven’t been able to do it. I just advocate keeping an eye on things and make sure you’re not buying at or near a peak and looking out for opportunities at or near the bottom of cycles. It’s worked out well for this humble punter.